Moral Hazard Facing the Many, to the Benefit of the Few

Several years ago, after American International Group (AIG) threatened some powerful players in the financial world with deserved extinction, the Federal Reserve and the U.S. Treasury extended massive financial aid to American International Group in 2008.  This assistance didn’t just keep AIG afloat – it helped AIG make good on insurance and other financial promises it extended to large banks and other parties in financial markets.  Some of AIG’s largest counterparties were actually based in Europe.  In effect, the American Taxpayer was standing behind American International Group.

Some of AIG’s largest exposures arose due to a financial instrument called a credit default swap.  These instruments allow one party (the ‘protection buyer’) to hedge themselves, or otherwise bet against, any financial difficulty for another party (the ‘reference entity’) by effectively paying a form of insurance premium to a third party (the ‘protection seller’).   AIG wrote massive amounts of protection against default on a wide range of instruments exposed to the housing crisis in the U.S., including huge pools of mortgage-backed securities and other derivatives.  When AIG couldn’t make good on its own promises backing these instruments, our central planners stepped in and saved the company and its counterparties.  That’s one reason we as taxpayers own a large majority stake in AIG today, a position on which we still have significant losses (to the tune of billions of dollars).

Credit default swaps and other forms of credit protection can be purchased on a wide range of financial exposures, including sovereign debt.   As the European crisis flared anew in recent months, the cost of buying protection against sovereign default has risen markedly.   A popular index of swaps on 15 Western European governments hit a record high of 385 on November 25^th, and remains near that record level.  This indicates that the cost of protecting against a default on Western European government debt has risen markedly, as it has become more probable.

But who is selling this protection?  How valid are their promises to make good on default insurance, if an event of default actually arises?

Assume, for the moment, that after the financial crisis of 2007-2009, large players in the financial system were increasingly ambitious in selling protection like this.  Getting some cash in the door in a difficult period can promote the willingness to assume this large ‘tail risk,’ but other factors may also have been at work.  After the AIG and related bailouts, some of the largest players in the market may have seen this as a relatively riskless way to get money in the door.   Given that the events sparking the need to pay out on the protection would also likely threaten the largest banks and other financial market participants, there may be an incentive for governments to stand behind the ‘protection sellers’ and make good on their promises with taxpayer dollars, a la AIG.

There may be safeguards against abuses like this, but history shows that laws can change in a heartbeat if the powers that be see fit during a crisis.

Capitalism at work?  Far from it.  Moral hazard facing the many, to the benefit of the few.

# # # #Bill Bergman has 10 years of experience as a stock market analyst sandwiched around 13 years as an economist and financial markets policy analyst at the Federal Reserve Bank of Chicago. He earned an M.B.A. as well as an M.A. in Public Policy from the University of Chicago in 1990. Mr. Bergman is currently working with Social Movement Sciences LLC, a new enterprise developing evaluation and funding services for not-for-profit organizations.

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